Citi and the Stress Counterfactual

Wed, Mar 14, 2012 | Jared Woodard

Fed, Market Commentary

Based on my understanding of the Fed stress test results, here’s an argument for why you should buy shares of Citigroup.

  1. Ceteris paribus, you should buy (short) shares of any bank that will have (will not have) adequate Tier 1 capital under the Fed’s stress scenario.
  2. If Citi revises its proposed capital actions after Q1 2012, it will have adequate Tier 1 capital under the Fed’s stress scenario.
  3. Citi is revising its proposed capital actions after Q1 2012.
  4. Therefore, you should buy shares of Citigroup.

Premise 1 obviously depends on your circumstances – I’m not giving advice, etc. If you deny P1, then you presumably don’t care as much about the stress tests from an investing point of view. I’m not sure I believe P1, but investors seem to believe P1 based on trading so far on Wednesday (C down 3%, USB up 0.9%). If you’re not an active investor, substitute an expressivist “hooray!” in lieu of buying or shorting shares.

The second premise is the key. Some people aren’t thinking in terms of P2 because they are focused on the third group of rows in the table on p. 24 (below), when what they should really look at is the fourth set.

In those bottom two groups, the Fed looks at the minimal capital ratios banks would have under their stress conditions assuming (i) that the banks proceed with the “capital actions” they have already proposed for today though the end of 2013. “Capital actions” apparently means the return of capital via dividends, the sale of securities that are counted as Tier 1 assets for the purposes of this test, and some other things; (ii) that the banks sit tight and don’t increase dividends or sell off cash-y assets.

Both scenarios are just counterfactual claims – counterfactual because the Fed regards the stress conditions as very unlikely. The scenarios describe very distant possible worlds. Given how unlikely the stress conditions are, you could even say that the two estimated scenarios are much more similar to one another than either one is to our actual world and its likely future state.

The reason the bottom set of ratios matters more is that, per premise 3, Citi is revising its proposed capital actions. (1, 2) In practice, maybe this means we hear about revised stress tests a few months down the line, or maybe Pandit’s “meaningful” payout is about as meaningful as the last page of any sell-side research piece. However it happens, though, Citi will make the changes needed to make the third group of revised numbers look more like the fourth.

And since the argument is valid, the conclusion follows.

Well, in truth, what probably really matters is how quickly and convincingly Citi makes those revisions. We could introduce some gradations into the second and third premises and make it a Bayesian thing. Since the implied volatility of C options is pretty low here, you could buy long-dated straddles instead. But hopefully you get the point: Citi’s “failure” is really just a counteroffer from the Fed in a negotiation about dividends.

Federal Reserve – Methodology and Results for Stress Scenario Projections (PDF)

Bloomberg: Pandit: Citi Aims for ‘Meaningful’ Shareholder Payout

Deal Journal: Citi Blog: We Did Not ‘Fail’ Anything

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More


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